A Simple Guide to Economic Double Taxation in India

 When a company in India does business with its parent or sister company abroad (called Associated Enterprises or AEs), they must set prices for these transactions as if they were unrelated parties. This is the "arm's length principle." If the Indian tax authorities (Income Tax Department) find that the prices were too high or too low, they can adjust the company's profits upwards, leading to more tax in India.

This creates a problem: the same chunk of profit might now be taxed in India (due to the adjustment) and also in the foreign country (where the other company recorded the original transaction). This is called economic double taxation—two different companies are taxed on the same income.

 

How Do Tax Treaties Help?

Most of India's tax treaties have a provision (based on Article 9(2) of the OECD Model) to fix this. If India makes a transfer pricing adjustment, the other country can make a "corresponding adjustment" to lower the profit of the company in its jurisdiction, thus avoiding double taxation.

However, countries don't automatically agree to this. They must be convinced that India's adjustment was correct. To reach an agreement, companies can use two mechanisms:

• Mutual Agreement Procedure (MAP): The tax authorities of both countries negotiate to resolve the dispute.
• Bilateral Advance Pricing Agreement (BAPA): Companies can get an agreement on their transfer pricing methods in advance for future years, preventing disputes altogether.

India's Changed Stance

Previously, India only allowed MAP or BAPA with countries whose tax treaties specifically contained the Article 9(2) provision. This blocked relief with key partners like Germany and France.

This changed in 2017. Following global guidelines (BEPS Action 14), India announced it would accept MAP and BAPA requests even if the treaty did not contain Article 9(2). This was a major shift to align with international best practices and provide relief to taxpayers.

The Big Unresolved Problem in Indian Law

There is a critical situation where double taxation remains, and it's due to a specific Indian law: the second proviso to Section 92C(4) of the Income-tax Act, 1961.

Here’s a simple example:

1. An Indian company pays ₹10 lakhs as royalty to its foreign parent.
2. It deducts 10% Tax Deducted at Source (TDS), so ₹1 lakh is paid to the Indian government on behalf of the parent.
3. Later, Indian tax authorities audit and say the arm's length royalty should only be ₹6 lakhs.
4. The Indian company’s deduction is reduced to ₹6 lakhs, so it effectively pays more tax.
5. However, the foreign parent has already received ₹10 lakhs and has been taxed on it in India via TDS. The Indian law (Section 92C(4)) does not allow a "corresponding adjustment" to reduce the parent's taxable income in India from ₹10 lakhs to ₹6 lakhs.

Even if the parent's home country gives relief via a MAP, it may not get a full foreign tax credit because the credit is based on the income "in accordance with the treaty." The parent company is often stuck paying tax in India on the original ₹10 lakhs, leading to definite double taxation.

Potential Solutions and The Way Forward

This loophole creates a significant hardship. Experts, including commentators on platforms like TaxByManish, suggest a few ways to overcome this:

1. Mirror APAs: Some multinationals now file two Unilateral APAs (UAPAs)—one in India for the Indian entity and a "mirror" APA in the foreign country for the parent company—to try and get the same price accepted by both jurisdictions.
2. Legislative Amendment: The most robust solution is to amend the Income-tax Act. The government could:
• Remove or amend the second proviso to Section 92C(4).
• Introduce a new mechanism that allows a non-resident to seek an adjustment in its own income once the transfer pricing adjustment in the Indian entity's case is final.

The rationale for the current law was to prevent companies from getting a refund for taxes paid on money they had already received. However, in the context of transfer pricing, which is about aligning with market prices, this rationale is seen as outdated and unfair.

In summary, while India has made great progress in aligning its treaty practices to avoid international double taxation, a specific domestic law continues to create an unresolved double taxation problem for foreign companies. A legislative change is the most awaited and comprehensive solution to this issue.